Understanding The US Mortgage Market Financial Crisis & Global Credit Crunch in 6 Steps

STEP 1

The Starting Point:

How political decision can be a cause of economic problem is found in the base of current US financial crisis. This financial crisis indeed started with the advent of a decision by the Clinton administration in 1994. In 1996, there would be a public election for electing president. Being a democrat, Clinton wanted to get the vote bank of 25% people of USA who didn’t possessed houses of their own. Clinton was definitely successful in achieving his political goal, but failed in terms of a economic manager if we consider the long run effect of that decision. Here in this article we are going to discuss the whole agenda in full detail to understand the situation better and we shall try to relate the phenomenon with the reality of Bangladesh.

STEP 2

The big flaw: Creating a Sub-prime Market

The sub-prime market differs from the prime market as it comprises all those people who do not meet the criteria for a mortgage in the mainstream markets. The adoption of the Depository Institution Deregulatory and Monetary Control Act in 1980 was part of the deregulation drive that eliminated many restrictions to lending, this resulted in loan reaching unprecedented levels which led to the mainstream mortgage market becoming saturated and reaching its peak of profitability. Those with patchy credit histories and of low income were turned away from mainstream mortgages at a time when the market was buoyant due to consumer spending and borrowing. The sub-prime market was carved out after this point as 25% of the US population fell into this category and represented a market opportunity. Hence US lenders gave mortgage to people who had little means to pay for a mortgage and charged them a rate of interest much higher than the commercial rate due to the increased default risk. They issued these mortgages sage in the knowledge that if the buyer defaults, then they would be able to repossess the property, and sell in a buoyant property market. By the start of 2007, the sub-prime market was valued at more then $1.3 trillion.

Traditional banks stayed away from this risky market and instead remained focused on prime lending and questioned some of the business practices of sub-prime companies such as their aggressive lending and accounting practices. Between 1994 and 1997 the number of sub-prime lenders tripled, gong from 70 to 210. because such institutions were not banks they possessed no customer deposits and in order to expand many lenders turned to the stock market for funding.

Companies such as Money Store, AMRESCO Inc, Dallas and Aames Financial Corporation, all raised capital through placing some of their companies on the stock market. Relatively young lender such as Long Corporation, Delta Funding Corporation, Irvine, California based New Century Financial Corporation, Delta Funding Corporation and Cityscape Financial all took their companies 100% public. By the end of 1997, the top 10 lenders accounted for 38% of all sub-prime lending.

STEP 3

Securitization

Most sub-prime lender then invented another of making money in a sector which was already highly risky. Many lender wanted to ensure they didn’t lose out at possible money making opportunities in the sub-prime market and developed a number of complex products; this was achieved by breaking down the value of the sub-prime mortgage market and various home loans in to financial sausage meat- just as wholesome as the real world equivalent- and selling them on to other institutions. Debt was sold to a third party, who would then receive the loan repayments and pay a fee for this privilege. Thus debt becomes tradable just like car. Hence the ability to securitize debt provided a way for risk to be sliced and diced and spread, thereby allowing more mortgages to be sold. Since 1994, the securitization rate of sub-prime loans increased from 32% to over 77% of total sub-prime loans. This process effectively increase the number of financial institutions with a stake in the sub-prime market. This was allowed to happen to the manner in which the original sub-prime loans were securitized.

Many institutions including mainstream Wall Street investment banks became owners of Collateralized Debt Obligation (CDOs). These are bonds created by a process of deconstructing and re-engineering asset-backed securities. This essentially works by proving investors with access to the regular payments received from debt payers in return for paying to have access to the CDO as well as management fees. Thus Wall Street investment banks made investment in the cash flown of the assts, rather than a direct investment in the underlying assets.

Many institutions also became owners of mortgage-backed securities (MBS), which were created out of the repackaging of sub-prime loans. In simple terms this is where a bank sells a set of debts as one product. In return for a fee, the new holder of this debt obligation receives the regular loan repayments. In most cases such a debt forms part of a pool of mortgage based debts lumped together into a form of asset or bond, each with different degrees of risk attached to them. Thus owners of MBS’s actually do not know the source of where the payments are coming from or even which sectors they’re being exposed to. The MBS market is worth $6 trillion currently, even more then US treasury bonds. The difference between CDOs and MBSs is in the later the property is placed as collateral. In any event of a downturn in the housing market, it would not only be the sub-prime providers who would lose out, but now all those who purchased collateral products would also be exposed.

STEP 4

The Role Of Credit Rating Agencies

Most debt carry ratings which indicate the amount of risk they entail, such a task is undertaken by credit rating agencies as an independent verification of credit worthiness. US home loans had been pooled and packaged into tradable securities by Wall Street banks, before being sold on to financial institution around the world. as they were bought and sold, these mortgage-backed securities were valued according to ther ratings given to them by the credit rating agencies. Credit agencies (dominate4d by the big three: Moody’s, S & P and Fitch) classify the risk of these repackaged securities according to their exposure to risky markets. CDOs were classified into tranches, the highest tranche was perceived to be very low risk and was often given an AAA rating- the same rating as high grade US Treasury Bonds. This is because in the even of default, the first to incur the loss would be the lower tranches and not the top tier. The mathematical models and simulations that the banks relied upon didn’t predict a scenario where defaults would become so numerous that even the top tier AAA-rated tranches would be affected.

STEP 5

Sub-prime Market Collapse & Effect On World Economies

As the housing sector continued to inflate due to the appetite for housing by Americans, the sub-prime sector continued to also grow. Commercial banks entered what they considered a buoyant market that could only rise, many Americans refinanced their homes by taking out second mortgages against the added value to use the fund for consumer spending. The first sign that the US housing bubble was in trouble was on the 2^nd April, 2007, when New Century Inc., the largest sub-prime mortgage lender in the US declared bankruptcy due to the increasing number of defaults from borrowers.

The crisis then spread to the owners of collateralized debt who were now in the position where the payments they were promised from the debt they had purchased was being defaulted upon. By being owners of various complex products, the constituent elements of such products resulted in many holders of such debt to sell other investments in order to balance losses incurred from exposure to the sub-rime sector or what is know as ‘covering a position’. This second round of selling to shore up funds and meet brokerage margin requirements is what caused the collapse in share prices across the world in August 2007, with the market getting into a vicious circle of falling prices leading to the further sales of shares to shore up losses.

What made matters worse was many investors caught in this vicious spiral of declining prices did not just sell sub-prime and related products, they sold anything that could be sold. This is why, share prices plummeted across the world and not just in those directly related to sub-prime mortgage. International institutes, who poured their money into the US housing sector realized they will not actually receive their money that they loaned out to investors as individual sub-prime mortgage holders were defaulting on mass on such loans; this resulted in all those who took positions in the housing sector not being able to pay the institutes they borrowed money from. It was for this reason central banks across the world intervened in the global economy in an unprecedented manner providing large amounts of cash to ensure such banks and institutes did not go bankrupt.

Major Sub-prime Losses (June, 2008)
Citigroup	$40.7 billion
UBS	$38 billion
Merrill Lynch	$31.7 billion
HSBC	$15.6 billion
Bank of America	$14.9 billion
Morgan Stanley	$12.6 billion
Royal Bank of Scotland	$12 billion
JP Morgan	$9.7 billion
Washington Mutual	$8.3 billion
Deutsche Bank	$7.5 billion
Wachovia	$7.3 billion
Others	$24.8 billion

The European Central Bank, America’s Federal Reserve and Japanese and Australian central banks injected over $300 billion into the banking system within 48 hours in a bid to avert financial crisis. They stepped in when banks, such Sentinel, a large American investment house, stopped investors from withdrawing their money, spooked by sudden and unexpected losses from bad loans in the American mortgage market, other institutions followed suit and suspended normal lending. Intervention by the world’s central banks in order to avert crisis cost them over $800 billion after only seven days.

STEP 6

Credit Crunch Across The World

Banks across the world fund the majority of their lending by borrowing from other banks or by raising money through the financial markets. As the realization dawned that sub-prime mortgage backed securities existed across the banking sector in the portfolios of banks and hedge funds around the world, from BNP Paribas to Bank of China. Many lenders stopped offering loans, some only offered loans at very high interest rates and most banks stopped lending to other banks to shore up their books. As no bank really knew how much each bank was exposed to the sub-prime crisis, many refused to lend to other banks, this led to credit crunch whereby those banks who made the majority of their loans from borrowed money found credit was drying up.

Northern Rock, the 5^th largest mortgage lender in UK, funded its lending by borrowing 80% from the financial markets. As the credit markets froze, it requested the Bank of England, as lender of last resort, for liquidity support facility due to problems in raising funds in the money markets. This created a run on the bank as depositors lost all confidence in the bank leading to queues developing across the nation as depositors withdrew their cash in panic. The British government took the controversial decision to nationalize Northern Rock as its collapse would have inevitably spread to other banks as panic stricken depositors attempted to withdraw their savings- the whole banking sector would have collapsed.